While there remains yet little evidence to support the argument for a ‘growth scare’, bond yields have remained stubbornly low in the face of rising inflation. As the graph below shows global negative yielding debt is again on the rise, approaching previous highs witnessed in 2019 and 2020.
Source: Strategas Research Partners
Corporates and governments alike have taken advantage of low rates to lock in record amounts of longer-term debt. There does seem to be value for the issuers of debt but the future returns of the buyers of this debt is laden with risk. The chart below graphs the ratio of US corporate bond yield versus its duration (a measure of interest rate risk). Very simply put, current holders of this debt have never received such a low premium (yield) for the interest rate risk they bear. It is almost as if the holders are certain that interest rates will not rise for the foreseeable future – or it may simply be a function of a lack of investment alternatives leading to a poor investment decision.
Source: Strategas Research Partners
More is being written about the faltering momentum of second derivative growth. That is, while growth in the economy and corporate earnings remains positive and strong, we will shortly be past the strongest of this growth. That hardly seems a damning observation given the comparisons to a global economy that was virtually in standstill one year ago. Investors seem to be giving little credit to the capacity of this economic and earnings growth to continue for some time at healthy levels. Indeed, as the series of charts below reveal, there is little evidence to be found to justify genuine concerns for an imminent end to the current global recovery.
The chart below shows one of the main measures of Euro area economic strength – combining activity in both manufacturing and services. While the US may be seeing peak growth, Europe still lags someway behind and is actually witnessing rising growth momentum as the service economy reopens while manufacturing demand remains at high levels.
Source: Strategas Research Partners
The price of industrial metals (increasing demand due to rising economic activity) relative to precious metals (commonly used to hedge against economic uncertainty) is often a reliable indicator of expected economic growth and therefore interest rates. While the prices of industrial metals have mainly consolidated during the past months, they have certainly not followed the direction of falling interest rates (graph below). One of these lines must give shortly – either rates are to rise or the correction in industrial metals must accelerate.
Source: Bloomberg Finance
Similarly, in times of rising economic uncertainty investors usually seek refuge in the most defensive segment of the equity market – Consumer Staples and Utilities. As the table below shows, the relative performance of these groups has been underwhelming in every environment so far in 2021. During the first quarter dominated by an inflation scare’, the second quarter more concerned over future growth, and in the past week marked by equity volatility. If correct, then there must be other explanations for the fall in government yields than the coming of a sharp economic slowdown.
Source: Strategas Research Partners
Finally, as we complete the second week of the Q2 corporate earnings season, there is no message from the companies reporting as to concerns over the sustainability of future growth. Indeed, as the graph below shows, early reports have led to further upgrades in corporate earnings expectations which are already at historic highs. As of July 1st, expectations for Q2 US earnings growth stood at a remarkable +65%. As we enter the third week of reports, expectations have already surpassed +72%, leading to upwards revisions for the full year and for 2022.
Source: Strategas Research Partners
Falling bond yields and rising earnings and cash flow growth inevitably leads to an advantage for stocks over bonds as an investment choice – absent the onset of an economic contraction. The graph below shows a simple valuation tool in assessing the relative appeal of the two asset classes. The dividend yield offered by the majority of US stocks is above that of long-term bond yields. In Europe, the relative appeal is even greater as dividend yields are higher, valuation levels lower, and bond yields at zero or even negative.
Source: Strategas Research Partners
While pockets of the market remain highly valued and should be avoided, the recent growth scare has resulted in decent price corrections in those stocks most sensitive to prospects for economic growth. The chart below highlights where the largest corrections have been realized (Energy, Materials, Consumer Discretionary and Financials). Money flows into these sectors have also reversed following a surge in the first quarter. This correction has not been accompanied by any negative earnings revisions. Therefore, these sectors have improved in value, offer market beating earnings growth and are no longer overcrowded from an investor position perspective.
Source: Strategas Research Partners
We have expressed our concern for some time of high valuations in the face of rising rates and optimistic investor sentiment. Our cash levels have risen as a result as we awaited better purchasing opportunities during the summer. The chart below highlights the return seasonality of the market based on three-month holding periods. Seasonality is simply one factor, but we are not surprised that it seems to be holding up so far this year as a weak seasonal period has met with elevated investor expectations and high valuations. However, with the reflation trade correction and rising investor concern, we will shortly enter a seasonal period of above average returns – from September. Investment opportunities are becoming more plentiful again and we do expect that our cash levels will start to decline as the summer progresses.
Source: Strategas Research Partners
